:: Oil Prices in the Coming Year: A Buyers Market

By Kevin J. Lindemer, President of Kevin J. Lindemer LLC

Oil prices have experienced the most dramatic changes in modern history. Prices moved from $55 per barrel to $145, and back to $55 in about 21 months. The collapse in prices from the peak of $145 down to $55 took place in only four months. While price volatility of this magnitude has inflicted pain on all participants in the oil business and those dependent on it and its products, it has also shown that markets do work. Supply and demand—producers and consumers—do respond to prices. And it is these responses that will drive the markets next year.

Oil demand growth in developed countries began to slow as early as 2005 as prices rose over $50 per barrel. Emerging market oil demand was largely unaffected even through last summer. These economies have been insulated from higher oil prices by the weak U.S. dollar and government subsidies on petroleum products sold to consumers. However, these factors are dissipating.

The dollar has risen in value quickly and is back to early 2006 levels. And, many countries have realized they cannot afford oil subsidies when prices are high and have either decreased or eliminated them. These two factors combined with slowing economic growth in emerging markets will result in slower oil demand growth in 2009.

In developed countries, the decline in oil demand will likely stabilize in the coming months. Lower prices will tend to increase demand growth, but a weaker economy will tend to prevent oil demand from rising. In the U.S., the drop in gasoline prices since mid-July has been about $1.88 per gallon. On an annual basis, this is equivalent to a savings of about $1,100 per licensed driver, which will have a positive impact on consumer spending.

The global financial crisis is also having a significant effect on oil demand. The global economy will likely grow by 1% or less in 2009, which will result in almost no growth in oil demand and, possibly, even a slight decline. This compares to the nearly 4% gross-national-product growth in 2007 with a corresponding 1.2% increase in oil demand. It is also likely that global oil growth for 2008 will also be near zero.

Three major factors will drive oil prices:
* Price responses—continuing impacts on supply and demand from the high oil prices of 2007 and 2008
* Income responses—weak U.S. and global economy
* Geopolitics—level of spare oil production capacity in OPEC and how OPEC manages it

Since at least mid-2008, oil supply has been increasing faster than demand, creating potentially unmanageable levels of spare capacity within OPEC, reminiscent of the 1980s and 1990s. OPEC spare capacity has increased to levels not seen since at least 2002 and is likely to increase further in 2009 as new production comes on stream and demand continues to weaken. To prevent prices from eroding further, OPEC must revert back to its historic role of balancing supply and demand to stabilize prices. However, OPEC could have difficulty maintaining production discipline in the coming year, because several of the OPEC countries’ national budgets for 2009 are based on oil prices above the crude oil price of early November 2008.

Given the continuing weak global oil demand and the much higher level of OPEC spare capacity, it is likely that oil prices in 2009 will remain below $65 per barrel on average, with volatility around this level, depending on OPEC’s success in balancing supply with demand.

Kevin Lindemer is President of Kevin J. Lindemer LLC, an independent energy research and consulting company based in Groton, Massachusetts, and has 25 years of experience in energy research, consulting, and the oil industry.